*The System Worked*

by on March 3, 2014 at 4:16 am in Books, Economics, History, Political Science | Permalink

That is the new and excellent book by Daniel W. Drezner and the subtitle is How the World Stopped Another Great Depression.  It is largely if not entirely correct, here is a summary excerpt:

A closer look at the global response to the financial crisis reveals a more optimistic assessment.  Despite initial shocks that were more severe than the 1929 financial crisis, global economic governance responded in a nimble and robust fashion.  Whether one looks at economic outcomes, policy outputs, or institutional operations, these governance structures either reinforced or improved upon the pre-crisis status quo.  The global economy bounced back from the 2008 financial crisis with relative alacrity.

I would myself stress two additional points, whether you call them addenda or qualifications is up to you.  First, we now know that the Fed could have done much more in 2008.  I consider this a mistake rather than a mistake in governance, and later the Fed did a great deal to try to make up for this error.  Second, the performance of the eurozone is hardly spectacular, to say the least, and the ECB should have moved to a much looser monetary policy in 2009 if not sooner.  Still, given what a screwy, seventeen-nation system had been set up, and given the severe distributional consequences of four percent inflation in the eurozone, I am surprised the system performed as well as it did.

So Much For Subtlety March 3, 2014 at 4:37 am

The System Worked? You mean having run a loose fiscal policy for too long, having socialized the banks’ losses through organizations like Fanny Mae and Freddy Mac, and having forced the banks to lend to sub-prime borrowers by threatening them with discrimination cases in court, the government was able to spend more money than any previous stimulus, producing eye watering levels of public debt and yet manage to produce the weakest recovery in recent history?

To me it looks like the System nearly killed the patient by giving him a rare form of cancer, but then managed to cripple him with chemotherapy which they, and this book, have shamelessly claimed is a cure. Myself, I can’t help thinking that what the System needs is less of the government trying to help.

But I have to admit I have not read the book and it wouldn’t be fair to leap to conclusions.

The Anti-Gnostic March 3, 2014 at 5:50 am

Yes, the system worked by printing up a couple of trillion dollars and handing it out to everybody. Or, more politely, by papering over the hole that suddenly appeared in nominal wealth until the “real” economy caught up.

So now we know the solution to rapid deflation of asset bubbles: print up money and hand it out. The Austrians would say this is banana republic economics: we are preventing the rich from becoming poor, and the malinvestments persist.

But here’s the thing: the Fed apparently really did avert the Great Correction. I think it’s the Austrians that have some explaining to do. OTOH, it seems kind of odd that of all regimes in history we’ve figured out what the Weimar Republic, the late Ottoman Empire, et al. could not. What’s different from then? I don’t know.

So Much for Subtlety March 3, 2014 at 8:24 am

What is the evidence the Feds averted anything? They are taking the claim for something that has turned out even worse than what they predicted would happen if they did nothing.

They have spent a massive amount and got a weak recovery out of it. I am willing to predict that this weak recovery will continue until we have a real Republican in the White House. Because I don’t think the spending did a damn thing – or at least not enough to off set the blows to confidence that all Obama’s other policies caused.

This is simply Lisa Simpson’s Tiger Repelling Rock. Not a lot of tigers in Springfield. The world didn’t slide into Depression either. Chalk one up to Lisa Simpson’s rocks.

Boonton March 3, 2014 at 5:15 pm

“They have spent a massive amount and got a weak recovery out of it. ”

‘Spent’ implies some limited resource that was used up trying to accomplish something. For example, if we lost half our aircraft carriers in a battle and only won control of some small, unimportant island, I would say that was a horrible outcome. But what exactly does the Fed ‘spend’?

VTProf March 3, 2014 at 8:10 pm

+ 1

CMc March 3, 2014 at 9:06 am

It seems malinvestments do persist. We’ll see

T. Shaw March 3, 2014 at 9:22 am

Bankers, lobbyists and politicians blew up the economy. Brilliant!

Then, they bailed out each other. Briliant!

Then, they created even more laws/policies/regulations impeding economic growth and misallocating capital. Brilliant!

The Fed, FDIC, FHA, FHLMC, FNMA, HMDA, HUD, SEC, UST, et al created “administrative” (e.g., housing, but also equities, bonds) markets with prices affected by government policies, not market forces. The house of cards fell in. Picture one of those inflatable, bouncy castles you can rent for your kid’s birthday party.

Then, they blamed the “market.” Brilliant!

Of course, “they” made buckets of money both up and down.

But, they’ll get it right. Next time . . .

Art Deco March 3, 2014 at 12:40 pm

The Austrians would say this is banana republic economics

They’re cranks.

JonFraz March 3, 2014 at 1:50 pm

In what alternate reality was money handed out to everybody? That couple of trillion dollars replaced a couple trillion that was vaporized during the crisis and the bulk of it by far went into bank reserves where it ceased to be part of the real world economy in any meaningful way.

The Anti-Gnostic March 3, 2014 at 3:28 pm

Okay. “…print up a couple of trillion dollars and hand it out to your friends in the banking industry.”

And hey, it’s worked so far.

Boonton March 3, 2014 at 5:18 pm

Not quite, the ‘banking industry’ didn’t get trillions of dollars. At least with TARP the banks got a ‘purchase’ of ‘preferred shares’ from the Fed. gov’t. Yes the banks got money but the Feds got shares which let them put the banks under their thumb. To get out of their thumb, banks had to demonstrate they cut their risks down and buy the shares back from the Feds. This is why TARP ended up almost breaking even.

The Fed does ‘print’ money but banks only take it as a short term loan. When the Fed wants it back or wants to raise interest rates on it the banks have to pay. So it’s not quite like dropping newly printed money from a helicopter over Wall Street.

john personna March 3, 2014 at 12:43 pm

We lived in a long sustained housing bubble in many regions. Government policy and government shaped 30 year loans didn’t turn the slope critical. That took private loans, securitization, funny AAA ratings, and derivatives.

Those last made the inflection point, and the hyper bubble.

Boonton March 3, 2014 at 12:49 pm

Yawn, there they go again with the whole “the bubble was made by mortgages to non-white people” line again. There wasn’t enough black people in the entire US to account for the bubble and this theory becomes laughable when you actually look at how the homeownership rates changed during the 2000′s.

john personna March 3, 2014 at 1:03 pm

When your coworkers become speculators, in beanie babies or flipping homes, you know the bubble is serious.

Boonton March 3, 2014 at 1:13 pm

It wasn’ t the housing bubble that was the problem, it was the bubble in mortgage based loans. Those are two different things. Housing prices have, like all prices, experience periods of increase and decrease. Even housing bubbles have come and gone long before 2007 (Florida, esp. has seen multiple rounds of booms and busts). What was so damaging to the financial system was the bubble in loans based on financial engineering.

A loan to a ‘risky customer’ with bad credit is not a problem for the financial system. Such a system should be able to put a price on such a loan that incorporates such ‘bad’ things just as much as it should be able to price a loan from an exceptionally safe borrower as more valuable. What was damaging, though, was the bubble in confidence that all risk in mortgage loans had suddenly been eliminated by the combination of financial engineering and house prices that would supposedly never start going down.

The system was premised not on people making their mortgage payments as on people taking out new loans. If in 2007 the gov’t did a massive bailout by paying off people’s mortgages, you’d still have a huge crash to content with since it was the inability of the system to keep churning out new loans that caused it to stop working.

john personna March 3, 2014 at 1:31 pm

I a making a more historical claim, that without the NINJA loans there would not have been the inflection and flipping frenzy – hence no need to “just” survive a nationwide housing crash.

And it was securitization that led to NINJA loans.

Boonton March 3, 2014 at 2:09 pm

That’s kind of like saying without sci-fi movies being popular there never would have been a Star Wars.

john personna March 3, 2014 at 3:26 pm

Yes, actually. Or without Costner movies there could be no Waterworld.

So Much For Subtlety March 3, 2014 at 11:13 pm

It is a mistake to conflate non-white with African American. There was a very sizeable growth in lending to Hispanics as well.

But even if numbers were small, it is trivial to construct a model where it would matter. The Banks were not allowed to Red Line. They had to lend in a way that was transparent to the regulators but did not discriminate – which ruled out leaving it to the local bank managers even where some were left. They had to have a paper trail. So they got rid of the managers’ judgement and replaced it with forms. Everyone got a form to fill out and no one was asked if they were lying. Thus the enormous growth in sub-prime loans.

Now the question is whether this model reflects what actually happened. I will leave that as an exercise to the reader.

It is important to make a distinction between a housing bubble and a home loan bubble. But the two were connected given the irrational view that all property prices were going to rise all the time. So no loan was a risk. Especially if they were bundled. One bad loan isn’t a problem. A lot of them are. As it turned out.

There is simply no denying the role that the regulators played in all of this. It is absurd to say the System worked when the System was a major contributor if not the final cause.

Boonton March 3, 2014 at 3:02 pm

“socialized the banks’ losses ”

Strictly speaking this never happened. Socializing the banks losses was the original idea behind TARP. “Hey Mr. Bank, here you have a thousand underwater mortgage loans that are bad…let us buy them for say $0.50 on the dollar. You’ll still make a loss but the loss won’t kill you because the taxpayers will be taking it.” That would have been socializing the losses. Instead TARP turned out quite different, essentially TARP turned into “Hey Mr. Bank, you still gotta handle those thosuand bad loans but the Gov’t is now going to give you a few billion in exchange for preferred shares and the gov’t making various demands on you like you increase your reserves. Don’t worry in a few years you can buy back those shares and be out from under our thumb”.

In the second case, taxpayers are keeping the banks from failing but are necessarily taking on the losses. In fact the taxpayers could easily end up profiting as the banks pay off the ‘help’ they are receiving. This is why people who make a big deal about the bailout have to tiptoe around the fact that the only net loss entailed to taxpayers was due to the auto company side rather than the much larger Wall Street side.

chuck martel March 3, 2014 at 8:31 pm

“taxpayers could easily end up profiting as the banks pay off the ‘help’ they are receiving”

Will they be sending the check for my share of the profits to the same address as on my tax return or will I have to fill out some paperwork?

We're all Keynesians now. March 3, 2014 at 4:58 am

We’re all Keynesians now.

Scott Sumner sock puppet March 3, 2014 at 7:51 am

umm… no.

Brian Donohue March 3, 2014 at 11:11 am

Judging by the comments here, it looks like we’re all Austrians now.

Have we lost the ability to distinguish between monetary and fiscal policy? Where are the monetarists?

dearieme March 3, 2014 at 5:42 am

How do you know that the past tense is justified?

steve March 3, 2014 at 6:10 am

If his premise about initial shocks is correct, it is clear that they system worked, compared with what happened in the 30s. It worked better in the US than in the EU. That doesnt mean it was an optimal response.


bob March 3, 2014 at 6:19 am

Indeed the system worked, exactly the way Goldman Sachs designed it to.

carlospln March 3, 2014 at 6:54 am

‘The system worked’

For whom?

Z March 3, 2014 at 8:23 am

Well, the over-class has done pretty well.

Chip March 3, 2014 at 7:20 am

Is the current and future cost of acquiring and repaying debt along with artificially low returns on savings offset against this supposed recovery?

When rates return to their un-manipulated level will the US’s extra $400 billion in interest be considered? And every year of sub par growth following what would likely have been a V shaped recovery after a severe correction – does that get tallied?

When stocks fall without free money, real estate unravels without subsidized loans?

This analysis resembles a debtor finding room on a credit card and celebrating with a bottle of Brut.

Boonton March 3, 2014 at 12:50 pm

“artifically low returns on savings”? What great oracle of economics is the correct rate of interest on savings?

Brian Donohue March 3, 2014 at 12:58 pm

I understand it’s tough sledding for the ‘extract wealth to fund Leviathan’ business these days, but it seems to me a non-negative real rate of return on savings is consistent with the observed fact that, ceterus paribus, humans prefer one util of consumption today to one util of consumption tomorrow.

5-year TIPS currently produce a negative real return of 0.28%. This is artificially low, and is only due to the Fed buying up most of the new bonds out there.

Boonton March 3, 2014 at 1:25 pm

Actually most ‘savings’ that takes place in nature is negative. The squirrel that piles away nuts for the winter never sees positive interest, only negative interest as at least some of his stockpile will rot or be stolen or lost. He ‘saves’ though not because he wouldn’t rather have a util of consumption today versus tomorrow but because he must or he will starve. Hence he accepts a negative real rate.

You confuse what a supplier wants with what should be. Of course a saver wants a positive return. A borrower wants a negative return. Between the two there’s no iron law of economics that declares the borrower never gets more of what he’d like than vice versa. In fact, it makes a lot of sense. If prices are signals, how would an economy signal that more consumption was required and less saving? Why a negative interest rate!

So it hardly follows that just because real or nominal rates are low or even negative that’s automatically ‘aritifical’.

Brian Donohue March 3, 2014 at 6:33 pm

This would be an excellent point if we were squirrels.

Boonton March 3, 2014 at 7:49 pm

Is that the best you can do?

Brian Donohue March 3, 2014 at 10:12 pm

Of course not, but it’s all your comment deserves.

Brian Donohue March 3, 2014 at 7:51 am

If we’re talking about the Fed, I think this is a reasonable view. The Fed was not responsible for the policies leading up to 2008. Fed actions since that time may have averted another Depression.

Also, Tyler, looks like you left out a couple words: ” I consider this a mistake [missing words] rather than a mistake in governance…”

Chip March 3, 2014 at 8:19 am

How did extremely low rates not contribute to the housing bubble and by extension, the financial crisis?

Brian Donohue March 3, 2014 at 8:34 am

Chip, here are historical yields on 1-year Treasuries. Help me spot the extremely low interest rates.

12/31/1999 5.98%
12/29/2000 5.32%
12/31/2001 2.17%
12/31/2002 1.32%
12/31/2003 1.26%
12/31/2004 2.75%
12/30/2005 4.38%
12/29/2006 5.00%
12/31/2007 3.34%
12/31/2008 0.37%
12/31/2009 0.47%
12/31/2010 0.29%
12/30/2011 0.12%
12/31/2012 0.16%
12/31/2013 0.13%

Chip March 3, 2014 at 9:35 am

The fed funds rate was cut to between 1 and 2% from 2002 to 2005, when rates returned to a more normal 5.25%. This then did wonders for ARM. Cue the crash.

Brian Donohue March 3, 2014 at 9:51 am

Fed funds rate, whatever. The rates I cited are actual rates- 1 year ARMs reflected these rates. The Fed cut rates during 2001-2003 (recession), then raised rates during 2004-2006. The started cutting again in 2007, after things started unraveling.

Art Deco March 3, 2014 at 12:32 pm

Per the Case-Shiller 10 city index, housing prices began to fly away from nominal incomes around about 1997 and continued in this vein until the Summer of 2006. The Federal Funds rate was abnormally low from the fall of 2002 to the fall of 2004.

Freddie Mac elected to slash underwriting standards in 2003. Nearly all the underwater mortgages ca. 2009 were first issued in 2004, 2005, 2006, 2007, or 2008.

Brian Donohue March 3, 2014 at 12:40 pm

I’m talking about the Fed here. Of course, there were policy mistakes in the late 1990s/ early 2000s among our elected officials.

Of the things you mentioned, only the Federal Funds rate reflects Fed policy. Above, I supplied data that I have no doubt tracks 1-year ARM rates pretty damn well and shows a clear pattern of Fed tightening between 2004 and 2006, with a rate as high as 3.34% as late as the end of 2007.

Boonton March 3, 2014 at 2:12 pm

The Fed’s job is to maintain full employment without inflation or deflation. Not micromanage bubbles. Yes if the Fed sank the economy in 2002 there never would have been a crash in 2007. Likewise if Bush had started a nuclear war with Russia and China on his first day in office we can very confidently say the 2007 bubble collapse wouldn’t have happened either.

Art Deco March 3, 2014 at 5:32 pm

Again, the Federal Funds rate was abnormally low for two years – from the fall of 2002 to the fall of 2004. The origin of the inflation in housing prices can be located in 1997 and that inflation continued for nearly two years after Fed policy changed. Attributing the trouble to Federal Reserve policy is anachronistic (but that does not stop those peddling Austrian nostrums).

Boonton March 3, 2014 at 12:53 pm

The Fed rates are for a single year of borrowing. Mortgages are borrowing that’s locked up from 15 to 30 years (or even more in some cases). Why would ‘too low’ one year rates cause a housing boom or bubble? If anything a market reaction to exceptionally low short term rates would be to *increase* long term mortgage rates.

Brian Donohue March 3, 2014 at 1:15 pm

The discussion was about ARMs. We can reprise it using long-term rates, but the general consensus (which I think is correct) is that the Fed has less control over the long end of the yield curve. This:

” If anything a market reaction to exceptionally low short term rates would be to *increase* long term mortgage rates.” is, I think, amateurish reasoning. The impact of changes in short-term rates on long-term rates is complex and ambiguous.

Boonton March 3, 2014 at 1:28 pm

Not really, if the impression is the central bank has ‘gone nuts’ and is printing money like wildfire to lower short term rates ‘artificially’ the natural market reaction is to raise long term rates since that’s a huge increase in the danger of future inflation (which if you’re going to lock your money up for 15-30 years is something you tend to worry about).

The discussion was about ARMs.

Few houses are purchsed with 1 year adjustable rate mortgages unless you’re talking about new construction or houses that buyers intend to ‘flip’.

Art Deco March 3, 2014 at 5:33 pm

Who has that impression?

Brian Donohue March 3, 2014 at 6:31 pm

@ Art Deco / Boonton,

Apparently no one has that impression, because, in this case, Fed policy has NOT caused long-term rates to spike, which is my point as to unpredictability.

Boonton March 3, 2014 at 7:57 pm

Here’s the problem, you’re claiming the Fed caused the bubble. How? Well by having short term rates be too low. How does that work? Well you say 1 year ARM’s fall because of that. OK but not many houses are purchased with 1 year ARMS. Ohh so long term went down because of the Fed’s short term activity. But then you say the reaction to the Fed’s short term activity is ambigious in the very long term. I agree, cutting today could mean inflation tomorrow….or it could mean a new period of lower rates. One would increase the long term, the other decrease it. So if the short term has no clear relationship to the long term then how is it again that the Fed caused the bubble?

Brian Donohue March 3, 2014 at 10:17 pm

@Boonton, reread my comments. I do not say the Fed caused the ‘bubble’ – on the contrary, I think the Fed did a pretty good job.

ladderff March 3, 2014 at 10:06 am

Pleases me greatly to see the commenters throwing this post back in the author’s face.

Still, it seems Whig history is alive and well and popular with the publishers.

Brian Donohue Impersonating Steve Sailer as an Austrian Economist March 3, 2014 at 10:20 am

We’re gonna get some hyperinflation REAL SOON NOW.

leftistconservative March 3, 2014 at 10:34 am

the system worked! Yay! The rich got richer! yay!
and the bottom 70% can eat beans, right?

fools March 3, 2014 at 10:50 am

From Amazon description of the book: “Daniel W. Drezner, like so many others, looked at the smoking ruins of the global economy”

Or, they could not lie their brains out and say we had a several day scary freeze up in money market accounts, and a fairly deep recession that doesn’t approach the phrase “smoking ruins”.

This fool, and Tyler drinking the kool-aid, know that the “schlerotic” institutions and their keynesian bullcrap saved the world about us much as ancient witch doctors knew their human sacrifices gave them a good next harvest.

sam March 3, 2014 at 11:44 am

Saying the system worked totally depends on the benchmark. Relative to the 30s, it worked. Relative to other moderate demand driven recessions, it failed. You could say that those past moderate recessions were qualitatively different – no financial crisis, no bank failures, no long term unemployed, no sweeping foreclosures. But that’s kind of the whole point…

ladderff March 3, 2014 at 2:18 pm

He said “demand.” Everybody drink!

Sebastian H March 3, 2014 at 12:27 pm

Hmmmm. Arguably the system caused and/or intensified the “initial shocks”, so avoiding the damage of the 1930s isn’t as impressive as we might hope for.

Art Deco March 3, 2014 at 12:38 pm

I think Charles Calomiris would take exception to this. IIRC, he said at the time that there were some fairly stereotyped procedures for exit from financial crises and that Henry Paulson et al threw the rule book away and took to mad improvising. It did not work out all that badly, but might conceivably have worked better.

Given that production levels reached their nadir in June 2009 before more than about a $1.95 worth of stimulus funds could be expended, I think its a reasonable proposition that the federal spending puke instituted by Congress and the President was not necessary to stabilize the economy.

One thing you saw was the Democratic Party default to fellating its clients. The biggest bloody money sink was the mortgage maws. Following that, the auto industry components were passel of losses. Even AIG did not approach these.

Todd Fletcher March 3, 2014 at 6:01 pm

A better question is why 99.9% of the profession never saw it coming! Something rarely talked about on MR

benjamin cole March 6, 2014 at 6:59 pm

Well, compared to a gold standard and no central bank backstop, the system worked.
Without central banks you could have has cascading and catastrophic worldwide disintermediation, a global conflagration of assets in a self-feeding financial fireball. It would be back to hunting with spears and digging tubers…you might happier though.

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